Following years of QE-inspired excess returns, investors in 2016 suddenly find themselves embroiled in a broad and brutal bear market. As BofAML's Michael Hartnett notes, the 10-year rolling return loss from commodities (-5.1%) is currently the worst since 1938...
Oil peak-to-trough -80% past four years, EM currencies trading 15% below their 2009 lows, yield on US HY bonds up from 5% to 10% in past 18 months, and equal-weighted US stock index down 25% from recent highs...
1470 global stocks (59% of the MSCI ACWI) are down >20% from their peak, and 913 are down >30% from their recent highs.
“Reset” or “Recession”?
In our view, the pertinent question for investors is whether the current bear market represents a healthy “reset” of both profit expectations and equity and credit valuations, or more ominously, the onset of a broader economic malaise that will require a major policy intervention in coming months to reverse.
The reset view:
The BofAML base case veers more toward the “reset” view and runs as follows:
On profits: lower trend GDP growth (Ethan Harris recently revised his forecast for US trend growth down from 2.0% to 1.75%), at a time of historically high profit to GDP levels, is inconsistent with the further strong advance that the consensus has penciled in the EPS (for example, consensus forecasts US EPS to rise 20% in the next 24 months would leave profits/GDP close to an all-time high – Chart 4); investor disbelief has caused the multiple to fall back in-line with its historical averages.
On policy: the Fed is likely to be as dovish as it needs to be to keep the economy and markets moving forward; the ECB and BoJ will do more; and the bear market "canaries in the coalmine", the oil price and the US$, have recently stabilized thanks to Fed hesitancy on rates and hopes that OPEC will cut supply.
On positioning: investors have already reset positioning… cash levels are high, uber-crowded longs in peripheral Euro-area debt, Euro-area banks, NKY, FANG stocks have been spanked; as is capitulation in "Illiquid" yield plays (EMB, HY, MLPs). Using the S&P 500 as our risk proxy, multiples have thus already adjusted from a peak of 17.2X, to 15.2X; using a historical average multiple of 14.4X, and leaving EPS levels broadly unchanged thus leaves investors with a reset target of 1795 (Table 4), which should act as a rough entry point for investors looking to add risk.
The recession view remains a more minority view. But it is nonetheless a big risk and, should it come to pass, would be expected to elicit a major policy response. The recession view runs as follows:
On profits: the 4C’s of China, Commodities, Credit, Consumer are all likely to deteriorate further, pushing the ISM index below 45, cementing recession expectations; China exports, China capital flows, a weak supply response from oil producers, as well as the reduced ability of corporations to issue debt to buyback stocks can all conspire to take economic data lower; in particular, the US consumer weakens (initial unemployment claims rise above 300k, US housing starts fall below 1 million, small business confidence falls below 95).
On policy: Quantitative Failure becomes more visible...since Japan expanded ETF purchases Dec 18th the Yen is +1.9%, Nikkei -10.3%; since ECB cut rates Dec 3rd the Euro is -0.1%, Euro Stoxx 600 -10.0%; since Fed hiked on Dec 16th the S&P 500 is -8.7%, 2yr yields are -18bps, 10yr yields -31bps; investors reduce exposure to risk assets in order to provoke a reversal of Fed policy (as was the case in 1937) or a bolder coordinated policy response (Chart 5).
On positioning: investors still OW stocks; a China/EM/oil/commodity "event" yet to create "entry point" into distressed assets; the long US$ trade yet to be unwound via a short-end collapse/Fed priced-out; and private clients are not yet in risk-off mode; in addition, the bid to global risk assets from Sovereign Wealth Funds falls sharply (there is currently $7.2tn in AUM at global SWFs, $4.4tn directly from commodity-producing countries), as capital repatriation back to distressed oil-producing countries reduce the bid for US Treasuries, prime real estate in London, New York, Geneva, luxury goods and services, hotels and "trophy assets" around the world (e.g. English Premier League and European football clubs – Table 5).
The recession result? Again using the S&P 500 as a risk barometer, in a recessionary scenario where EPS falls 10% and PE contracts 20% peak-to-trough, a target for SPX would be 1575-1600.